Tactical Asset Allocation Strategies – Improve performance and reduce risk by shifting exposure as market conditions change

TAA is another way to improve the return versus risk profile of an investment portfolio

Tactical Asset Allocation Strategies
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Tactical asset allocation is another way to improve the return versus risk profile of a portfolio of investments. In this post we look at a few tactical investment strategies you can use to rotate capital between different sectors of the stock market, bonds, and other suitable asset classes according to economic and market conditions. We discuss different strategies to use, and the pros and cons of tactical asset allocation.

Strategic vs. tactical asset allocation strategies

Asset Allocation
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Asset allocation is typically quite static. The goal is to create a mix of assets that will achieve the required return over the long term, with the lowest possible volatility. Historical market data is used to optimise the asset mix in order to maximise returns for an acceptable level of volatility.

The weight of each asset class will be adjusted gradually over time. Changes will only be made to tilt the objective from capital growth to capital preservation and cash flow generation. Apart from these gradual changes, the portfolio must also be rebalanced to keep the asset mix in line with the model. This approach to the asset mix is strategic asset allocation.

Tactical asset allocation, also known as TAA, can be implemented in addition to strategic asset allocation. Tactical asset allocation strategies adjust the asset mix slightly as market conditions change. The goal is to reduce exposure to risky assets when conditions are unfavourable, and increase exposure when conditions improve.

Tactical Asset Allocation
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Broadly speaking, tactical asset rotation moves capital between two groups of instruments:

  • Risk-on assets: Equities, emerging market equities, bonds and high yield bonds.
  • Risk-off assets: Gold, AAA rated bonds, cash.

Strategic asset allocation may indeed achieve the desired returns over the long term. However, as we saw in 2000 and 2008 market prices can fall a long way in the short term. This can create anxiety for investors which can lead to irrational decisions – often at the worst time possible.

If economic factors, price action or fundamental analysis clearly point to a heightened level of risk, it makes sense to reduce exposure to the riskiest assets. A successful shift to asset classes that outperform when volatility increases, can reduce losses for the overall portfolio. This will also leave the portfolio with more buying power when prices are more attractive. Tactical shifts do not involve an entire portfolio – the total percentage of a portfolio exposed to tactical shifts is usually between 5 and 20%. A tactical shift would look something like this:

Asset class: Strategic weight:Change:New weight:
Equities:50%-10% 40%
Bonds:20%+5%25%
Alternatives (incl. gold):20%+5%25%
Cash:10%0%10%

TAA is not the same as stock picking or active management. These occur at the individual security level whereas TAA occurs at the asset class level. TAA is an active allocation strategy. While strategic asset allocation is based on historical data, tactical asset allocation is based on the investment environment at any given time.

Guidelines for tactical asset allocation

Tactical Asset Allocation Guidelines
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There isn’t one specific way to make tactical shifts to a portfolio. In fact, it’s advisable to design your own strategy that suits your level of expertise, resources, and time constraints. The following guidelines are worth considering. Decide on a percentage of the portfolio that you will shift between different asset classes. This could be between 5 and 15% of the entire portfolio. You may wish to start out with a smaller percentage and increase it as you become more comfortable with the strategy.

Some TAA strategies use three different levels to define the level of risk in the market. When risk is lowest, the tactical portion is allocated to riskier assets. When the risk level is average, the tactical portion would be spread across all assets, bringing the portfolio back in line with the strategic allocation. When risk is high, the tactical portion of the portfolio would be allocated to safe haven assets.

Stock Market Analysts
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TAA should not be used as a market timing strategy, but as a method of improving returns and reducing risk. The distinction can become blurred, so where possible a systematic approach should be used. Tactical asset allocation strategies can be discretionary or systematic. A discretionary approach would make use of factors that are more difficult to measure, but are informative, nevertheless. These may include chart patterns, technical support and resistance levels and some economic indicators.

A systematic approach would use data that can be back tested. Technical indicators like moving averages and economic indicators like inflation and interest rates can be used to build a strategy that can be tested on historical data. Increasingly, market sentiment is being used for systematic trading strategies, and can also be included in a systematic TAA strategy.

Instruments for TAA strategies

Strategic asset allocation strategies require only limited trading. Positions must be rebalanced to keep the portfolio in line with the target asset allocation. The allocation may also be adjusted incrementally over time, but this can often be achieved when rebalancing takes place. The net result is very low turnover, apart from years when asset class performance diverges substantially. Tactical asset allocation requires far more trading. For this reason, the choice of instruments is important. Liquidity and trading costs become crucial the more active a strategy becomes.

ETF Investing
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Index funds are more commonly associated with passive investing but can also be used to shift exposure without incurring large trading costs. ETFs (exchange traded funds) are ideal for TAA provided they are liquid and have low management fees. These funds will cost little to trade and hold and can cover all the relevant asset classes. The following are US listed ETFs worth considering, though equivalent funds are listed in other markets.

Risk-On ETFs

  • International Equities:
    • Vanguard FTSE All-World ex-US (VEU)
    • iShares MSCI ACWI ex U.S. ETF (ACWX)
  • US Equities:
    • Vanguard Total Stock Market ETF (VTI)
    • SPDR S&P 500 ETF (SPY)
  • European Equites:
    • FTSE Europe ETF (VGK)
    • iShares MSCI Germany ETF (EWG)
  • Asian Equities:
    • Vanguard FTSE Pacific ETF (VPL)
    • iShares Core MSCI Pacific ETF (IPAC)
  • Emerging Market Equities:
    • Vanguard Emerging Markets ETF (VWO)
  • US Equity Sectors:
    • Communication Services (XLC)
    • Consumer Discretionary (XLY)
    • Consumer Staples (XLP)
    • Energy (XLE)
    • Financials (XLF)
    • Health Care (XLV)      
    • Industrials (XLI)
    • Materials (XLB)
    • Real Estate (XLRE)     
    • Technology (XLK)      
    • Utilities (XLU)
  • REITs:
    • Vanguard Real Estate Index Fund (VNQ)
    • iShares Mortgage Real Estate ETF (REM)
  • High Yield Bonds:
    • iShares High Yield Corporate Bond ETF (HYG)
  • Emerging Market Bonds:
    • iShares JP Morgan USD Em Mkts Bd ETF (EMB)

Risk-Off ETFs

  • Cash:
    • iShares 1-3 Year Treasury Bond ETF (SHY)
    • SPDR Barclays 1-3 Month T-Bill ETF (BIL)
  • Treasury Bonds:
    • iShares 20+ Year Treasury Bond ETF (TLT)
    • Vanguard Short-Term Treasury (VGSH)
  • Gold:
    • SPDR Gold Trust (GLD)

It may be tempting to consider leveraged ETFs and inverse ETFs. After all, leveraged ETFs require less capital to achieve a given level of exposure, and inverse ETFs can be used as a hedge. However, these products should be treated with caution. The way both of these types of ETFs are structured can result in unexpected price movements. Because derivatives are used they do not always correlate with the underlying index.

Alternative asset classes and tactical asset allocation

Asset Allocation / Diversification
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Asset classes like hedge funds, private equity, venture capital and direct real estate are not typically part of a tactical asset allocation strategy. Rather they can be thought of as complimentary investments.

Private investments are less liquid which means their values are not as volatile as stocks. Including them in a portfolio can therefore reduce the overall volatility of the portfolio. The drawback is that they are not suitable for active strategies and so should be excluded from a TAA strategy.

Hedge funds are more active than most funds and make use of leverage and short selling. Some of the objectives of TAA can therefore be achieved within a hedge fund. Catana Capital’s Data Intelligence Fund, for example, uses real time data to respond to changing market conditions. Furthermore, trading decisions take market sentiment into account. So, there is no need to include a fund like this in a TAA strategy, but rather it can be held as a complimentary approach to reducing portfolio risk.

Commodities and precious metals can be included in a TAA strategy if they are liquid and trading costs are low. Commodity derivatives and ETFs are more suitable to a tactical approach than direct exposure is.

Common types of TAA strategies

Analyzing Charts
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As mentioned, TAA strategies can be discretionary or systematic. A systematic approach removes guesswork, emotion, and bias from the equation. This doesn’t mean a discretionary approach won’t work but will require more discipline.  

Momentum based TAA strategies

Momentum based tactical asset allocation strategies are generally best suited to the average investor. They are both easy to understand and easy to implement. Using momentum as the only input is also efficient in terms of the time it takes. A momentum based TAA strategy will help you to reduce exposure to riskier asset during large corrections and bear markets. The downside of this approach is that there will be false signals which may reduce performance over the medium term. The objective of using momentum to adjust an asset allocation is to work with price trends.

By being overweight outperforming assets and underweight underperforming assets, a portfolio benefits from continuations of those trends. You can use actual returns over a specific time period, or you can use moving averages to compare the instruments you are using. A popular approach is the dual momentum system developed by Gary Antonacci. His system uses absolute momentum and relative momentum, which are measured using the 12-month return.

Trading Graph / Chart
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This is a very simple system which rotates between three ETFs and uses a fourth ETF as a benchmark for cash. The first three ETFs represent the US equity market, the global equity market excluding US equities, and the US aggregate bond market (government and corporate bonds).

The following table illustrates the way moving averages can be used to measure relative momentum. It reflects the latest price, the 125-day moving average and the 250-day moving average for three funds: The S&P 500 SPY ETF, the Vanguard Emerging markets ETF and the Vanguard short-term treasury ETF.

ETFPriceShort MALong MAShort – LongPercent
SPY321301290113.4
VWO4441.741.60.090.2
VGSH6160.960.60.30.4

The 125-day moving average is an approximation of the average price over the last 6 months. The 250- day moving average approximates the average price for the last year. By subtracting the longer average from the short average, you can compare the two averages, without the values being affected by short term volatility.

Dividing the result by the ETF price gives you a momentum metric that you  can use to compare several ETFs. In the above example, SPY is much stronger than both the emerging market and short-term treasure ETF. It therefore makes sense to hold SPY. If both equity funds were weaker than the treasury ETF, it would make sense to hold that one. You would switch to the emerging market fund if its momentum was stronger than both the SPY and the treasury ETF.

Other types of TAA strategies

Analyzing Financial Figures
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There are several other approaches to TAA which are more complex but may be worth considering.

  • Global Tactical Asset Allocation brings some of the tactics of global macro hedge funds to multi asset portfolios. Macroeconomic indicators are analysed to identify probable scenarios for major asset classes around the world. Typically, equities, bonds and currencies are included in such a strategy.
  • Cyclical tactical asset allocation strategies use a scoring system to identify the stage of the market cycle at any given time. The asset mix is then shifted to the asset classes that tend to outperform during the current stage of the cycle.
  • Value based TAA strategies use value metrics to allocate capital to markets that are undervalued. Typically, the CAPE (cyclically adjusted PE) ratio of each country’s headline index is compared to historical levels. Capital is then rotated out of historically expensive markets and into historically cheaper markets. Value metrics can also be effectively combined with momentum strategies.

Pros and cons of tactical asset allocation strategies

Pros / Cons Tactical Asset Allocation Strategies
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The primary objective and advantage of a TAA strategy is that exposure to risky assets can be reduced during periods of uncertainty and volatility. Long term investment portfolios with a static asset allocation can experience significant drawdowns during bear markets like the GFC in 2008. It can take a long time for a portfolio to recover from such a drawdown. Tactical asset allocation can also give you more buying power after a substantial decline in stock prices. In addition, they are a mechanism to lock in gains after an extended bull market.

However, like most investing strategies, tactical asset allocation strategies are not without certain drawbacks. No strategy is fool proof, and a tactical shift won’t always lead to improved performance. It is difficult to time a strategy perfectly, and timing can have a large impact on performance. This is the reason tactical shifts should be limited to between 5 and 20 percent of a portfolio.

TAA is also more time consuming than strategic asset allocation and straightforward passive investing. In addition, more expertise is required – TAA is not suitable for those new to investing.

Conclusion

Investors must hold some risky assets to generate long term returns. However, there are periods when a large allocation to equities and emerging market assets doesn’t make sense. TAA is one way to reduce this sort of exposure. The growing prominence of algorithmic trading and quantitative investing is likely to give investors more tools to use to make sensible tactical shifts in a portfolio. This means tactical asset allocation strategies will be more widely used in the future, especially if volatility returns to equity markets.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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